Jim Fasano thinks some private equity firms aren’t trying hard enough. Fasano, who oversees the Canada Pension Plan Investment Board’s allocation to private equity funds, secondaries and co-investments, has been driving the public pension fund’s move into co-investment deals like the $6.3 billion privatization of San Antonio, Texas–based medical device maker Kinetic Concepts with London’s Apax Partners in 2011, as well as cornerstone investing with promising new firms such as Dallas-based Kainos Capital. An engineer by training and a former commissioned officer in the Canadian Armed Forces, Fasano is responsible for some $23 billion of Toronto-based CPPIB’s $182 billion in assets; with his help its private investment arm posted a 13.6 percent return for the fiscal year ended March 2013. Before joining the fund in 2004 to lead its principal investing unit, he was an investment banker at Merrill Lynch focusing on media and telecommunications. Fasano, 44, spoke to Contributing Writer Simon Meads about private equity co-investing and picking the deal makers of the future.
What’s a big trend in private equity these days?
One trend that we worry about is what appears to be a reduction in underwritten returns by some firms focused more on capital deployment than on maximizing returns. There seems to be some movement toward high-teens gross returns or low-teens net. The risks and costs associated with private equity funds are not justified by low-teens net returns. This is even more concerning at the moment, given the aggressive capital structures being used to get to even those returns, with no adjustment for the increased financial risk.
Most institutional investors say they want to do more co-investing with private equity managers. Are you finding it a very competitive space?
Whereas co-investments used to be a bonus, some limited partners are now counting on them to make up for lower fund net returns, and we are seeing more cases where guaranteed co-investments are sought as a prerequisite for a fund commitment, essentially diluting fee and carry [performance fees] paid on the fund commitment across a larger amount of invested capital. Our concern over an increasingly competitive co-investment market is a potential race to the bottom, lowering diligence standards, governance, etcetera to ensure allocation.
As an investor, what skills and infrastructure do you need to be able to co-invest and invest directly in companies, and are most institutional investors set up for it?
We are big believers in the biggest needs being having the talent to execute properly and being able to execute to tight time lines without compromising standards. Being able to attract and retain this talent is one of the largest challenges for many limited partners. You also really need people on the ground in the region. For example, doing an Asian co-investment with a team based in North America can be a deal breaker with many general partners. Finally, one factor many people don’t think about is a proven, transparent approval process. If a GP is surprised at the finish line by a co-investor, it will often lead to fewer opportunities going forward.
Are there enough deals around for all investors, and will everyone be happy?
No. Given the current demand for co-investment and the amount of dry powder in GPs’ hands, I can’t see a situation where everyone can be happy. If investor co-investment demand were to be fully satisfied, I doubt the managers will have gotten their desired amount of equity invested!
We believe that firms that have the appropriate teams in place and can execute well and transparently will ultimately get their share of co-investments. Allocation of scarce co-investment opportunities will be a significant challenge for managers.
Are big investors missing out on opportunities with smaller private equity managers because their investment amounts are too large?
To achieve significant outperformance we feel you need access to certain middle-market managers. One of the ways to achieve that is being a cornerstone investor in first- or second-time funds from managers we think have great long-term potential. The reason we have gone down that path is we are always looking for opportunities where we can receive strong future investment performance and also build a strong long-term strategic relationship. One of the most important elements is being able to invest alongside each other, be that more typical co-investment or a model we follow that we call co-sponsorship, which is really co-leading deals — a deal that is too large for them to do on their own and where CPPIB is an equal or near-equal partner.
In 2013 we backed the food industry team from within [Dallas-based] HM Capital to spin out and launch its independent life as Kainos Capital. We also acquired the existing food assets from HM in a separate deal. This team had already begun to spin out; it was known they were going to be spinning out and fundraising on their own. Through the transaction, we subsequently made a large commitment to their new fund and gave them a lot of momentum in their fundraising.
Does the strategy of backing first-time funds have any benefits or applications outside your private equity business?
We also have a private debt team that sources attractive opportunities. That’s one element of getting a strong strategic relationship. And in some geographies where we aren’t well-established ourselves, we can get a lot of benefit in terms of market intelligence and help with some of our other businesses within CPPIB, if it is a firm that has a strong network and strong relationships in a region. We do have an equivalent team within our public markets group that backs hedge funds. They would back equivalent emerging hedge fund managers in a way similar to what we do in private equity.
Do you expect higher rewards from backing this strategy?
Better rewards are definitely one side because in a particular geography or because of a particular team we expect them to do better than some of our other managers, though, frankly, that is a pretty high bar. Sometimes we will have some preferential economics as the cornerstone investor; peripheral opportunities like co-investment is another way we can get better returns. The other element we focus on is stronger governance. So if it looks like [the new firm] isn’t going to work out, we have the ability to protect our capital better than we might in a more well-established fund.
So there are higher risks too?
The big risk with a first-time fund is that if it is clear that early results aren’t going well, the partners come to the conclusion they are not going to get carry from a fund and they have very little incentive to stick around. They don’t have prior funds with carry coming in or a valuable brand that they know will allow them to raise a successor fund despite this one weak fund. Retaining a team is very important, so there are things like the key-man clause. In other words, if too many of the key people leave the firm, it cuts off new investment.
